
This blog post is titled "buying a house." So what in the heck does that have to do with the cool, souped up gull wing car to the left (a photo I snapped while walking to work a few days ago, when it wasn't raining) - we will get to that...
I often hear the phrase "buy a house". Really. Let's think about what that really means.
In the vast, vast majority of cases, people don't buy a house. Here is what happens:
- You enter into a contract with the seller
- You obtain financing from a financial institution
- This financing involves the bank loaning you the principal amount (sales price) in order to purchase the house, for which title moves from the seller's bank (usually) to the buyer's bank
- You agree to pay the bank interest in addition to repayments of principal
- You may pay fees for the mortgage, or title insurance, etc...
- The seller pays the real estate agent (you are neutral to this, except that you probably paid a higher price than you would have if you'd have bypassed the agent and purchased directly from the buyer, and you could have split the 6% savings and come out way ahead)
- The lawyer is paid for his work
- The city or municipality often receives a fee based on the sales price
- You owe and begin paying property tax on the residence owned by the bank
- You are responsible for upkeep and maintenance on the house, in accordance with the area you live in and your own goals for remodeling or enhancements
All of these items above are negative items, all financially injurious to the buyer. Here are the benefits:
- You no longer pay rent to someone else. You live "rent free" in your own house
- IF the property appreciates in value, AND you find a buyer willing to pay the higher amount, you may be able to sell the property (owned by the bank) to this buyer and you would pocket the gain on sale after paying off your loan. Note that this "gain" needs to take into account the "rent free" months you lived in the house, but then subtract all of the fees along the way and all fo the investment in terms of time and money that you put into the home
- Any interest that you pay (up to a high amount) is deductible on your taxes along with points and some other items, for both your regular taxes and the AMT (alternative minimum tax)
- Any property taxes are deductible for regular taxes but NOT for the AMT
- If you sell the house for a gain, you may be liable for taxes, but with the broad exclusions on gains for homes and the average person won't pay taxes on the home. Plus, capital gains rates are now very low (15%)
Many financial advisors point to the fact that people without houses (renters) have a very low net worth, and people with houses generally have a much higher net worth. Thus, they conclude, homeowning is a sign of wealth building and a recommended course of action.
This methodology or "common sense" idea that home buying builds wealth is probably true if you view it as a forced savings vehicle, assuming that the average person would consume rather than reinvest their savings. If, however, you assume that the average person would invest the savings and then these savings grow with the effect of compounding interest and gains on stocks, then the picture is probably different. As an asset class, there have been good returns on housing, but there also have been better returns on other sectors. Even though home prices have been going up, commodities, for instance, have been skyrocketing (such as oil from $20 / barrel to $70 / barrel, a 350% gain).
The real problem with the methodology is that this system and common perceptions of real estate in terms of your personal home being a "good investment" is that people tend to buy much more "house" than they would if they had to rent. You don't often see giant 4,000 sq. foot homes for rent, but open the Chicago Tribune and you will see page after page of McMansions
for sale. Thus the whole "free rent" value, while substantial, is mostly nullifed by the fact that 1) you are buying much more than you'd likely rent 2) you are paying interest, property taxes and maintenance / upkeep on the property, costs that would be borne by the landlord, not you, if you rented (although no landlord is going to run a building for long at a cash flow negative level).
In fact, this game is getting riskier and riskier for participants, due to the following reasons:
- individuals are taking out
riskier loan instruments to finance the "purchase" (their bank taking title, that is). These often involve "interest only" loans, often with a "teaser rate" that is low initially but moves up with future interest rates. Since there is less principal paid down each time, the odds are higher that in case of an adverse personal event (job loss) or market event (downturn in the local market) that the buyer could go negative in terms of equity at which point a lot of bad options, such as walking away from the loan and sticking the bank with the loss, come into play
- the
market is very high already, so the risk of loss in a downturn is significant (which compounds the risks above). The bull market cannot continue forever, especially since it encourages more homebuilding which in turn accelerates the likely downturn due to excess supply on the market
-
property taxes are going up rapidly, because both rates are going up (they never go down) and the assessed value (what the city thinks your home is work) is also increasing due to the market froth. Thus the cost to carry the home is getting worse every year
- the
AMT wipes out a significant portion of the total deduction related to property taxes, which can add up to thousands of dollars in tax "shield" lost
Really, what it is, is what a friend of mine in the business said you need to do to MAKE money. You need:
1) concentration
2) leverage
In fact, a house meets both of these. If you have an interest only loan and put down almost no money, AND the market is frothy and you find a buyer, you can sell the house for a big gain even after paying all the fees and costs AND you get tax benefits, to boot. And the bigger the house you bought and the less money you put into the deal, the bigger your gain on what you DID put into the deal.
However, my friend is wealthy and his customers are wealthy. They can AFFORD to take these types of risks to get even richer, but the average person (who ties up all of his net worth into the house) CAN'T take those risks in a prudent way, because if it backfires they will be wiped out.
I'm not saying real estate can't work for a lot of people, and that it can't grow a lot of wealth. IT CAN. However, it is a risky crapshoot of an item, especially given the risks I lay out above. I don't think people are fully considering these risks, nor are they giving themselves much of an "escape hatch" should things go wrong. If you REALLY want to make money in real estate, buy a two flat and rent part of it and fix it up yourself, buy raw land, or get into commercial real estate. Note that none of these items involves buying yourself a giant house to live in and then pouring money down the rathole of expensive furnishings and finishes, which are essentially consumption, not investment. Another way to go is to buy your house outright, and live rent free. This method doesn't give you a tax advantage but is an excellent benefit, especially if you aren't earning a lot on your investments.
Also, it incentivizes the economy the wrong way. By giving a tax break on interest, it punishes those that own their homes outright. By shielding from taxes, it encourages people to "trade up" to more expensive houses, thus increasing an investment in a non-productive sector of our economy.
Back to the post - when most people talk about buying a home, they talk about practical things like schools, their sense of owning something in a community, the tax shield, and the financial benefits. This would be like buying a used Honda Accord for cash outright to get to work and run errands.
In reality, however, they are (mostly) doing the equivalent of the exotic car above in taking something that can be used for a practical purpose (a place to live) and making this the Trojan Horse for a sea of expensive upgrades and luxury living that really aren't cost effective (unless the market continues to go nuts, which it is unlikely to do over the next 3-5 years). You wouldn't rent those thousands of square feet, but you would buy it, and say it is because it is a good investment. But is it, really? And why is the government subsidizing you every which way so that you can stretch your budget to take out a bigger bank loan? It doesn't make sense.
But that is just my opinion... and it is a lonely one in these days of flimsy mortgages and sky high valuations...